Will Third Time Be a Charm for Toxic-Asset Solution?

Despite pronouncements that a financial meltdown has been averted, a recent report from the Congressional Oversight Panel observed that toxic assets continue to pose a threat, especially for smaller banks that face mounting losses on their commercial real estate loan portfolios.

But neither attempt by the federal government to address the problem of toxic loans - the Troubled Asset Relief Program and the Legacy Loans Program (which is part of the Public-Private Investment Program) - ever got off the ground. Despite larger banks' recent success at raising capital, a real and sustainable banking recovery is not going to happen anytime soon without a politically palatable and bank-tolerant emetic to purge the financial system of toxicity. The COP report, citing uncertainty about whether the troubled assets remaining at banks can again become a trigger for instability, called on the Treasury Department to adopt an effective program to purge these assets from bank balance sheets.

A small team of structured-finance professionals and distressed-debt specialists has devised a different approach to the toxic-asset problem that avoids the sale paradigm of TARP and PPIP altogether. This solution, known as a Distressed Asset Restructuring Trust, or DART, works as follows: A bank transfers its toxic assets to a newly created, wholly owned subsidiary (the trust) whose sole purpose is to hold, manage and work out those assets. The bank receives back two different instruments issued by the trust: debt instruments (trust certificates) and equity instruments (residual interest). The trust certificates will be sized according to an intrinsic-value stress test that is applied to each asset transferred. This test will project recoveries on the assumption that these assets will be held by the trust until their final maturities.

Since this test will be based on a time horizon extending to the final runoff of the assets, the calculation will take into account assumptions about future market absorption, future economic conditions and other external factors affecting performance. Just as importantly, the test will not assign a present value to the projected recoveries at the double-digit yields that private-equity buyers are seeking but will instead use discount rates that banks are comfortable receiving on their assets.

The government's involvement comes at this point only: The DART architects propose that the Federal Deposit Insurance Corp. or the Treasury provide limited guarantees that the recoveries projected under the intrinsic-value stress tests will in fact occur. These guarantees will only be enforceable after all the assets in the trust have run their course and the actual recoveries are known; they will require payment by the guarantor only to the extent that the total recoveries fall short of projections.

The federal guarantor will receive cash payments from the trust sufficient to compensate it for providing the guarantee. Thus, there is no federal "subsidy." Since the guarantee is based on the stress tests, it is not expected that the shortfalls on the pools will be material, if they occur at all.

Under DART, banks would be exchanging nonperforming assets (assigned a risk-weighting of 100 percent to 200 percent for regulatory capital purposes) for certificates with a risk weighting of 20 percent (based on the FDIC guarantee) or 0 percent (if guaranteed by the Treasury). Thus, the banks' capital ratios will be dramatically improved upon the exchange of the assets for the DART certificates. For example, a bank that exchanges distressed assets for 20 percent risk-weighted DART certificates could reduce its regulatory capital requirements attributable to the transferred assets by more than 70 percent.

Capital relief is, of course, only part of the prescription for restoring banks to fiscal health. Capital infusions are also essential. A second and equally important benefit of DART is that the federal guarantee on the DART certificates received by banks would define with certainty and finality each bank's exposure to toxicity, thus letting it raise capital more cheaply from the private sector and resume its primary function of making loans. Also, DART provides maximum flexibility to participating banks: The certificates as well as the residual interest in the DART trust may be retained by the bank or distributed to shareholders or third parties.

Other proposals have some elements in common with DART, including the good bank-bad bank structure and the FDIC loss-sharing agreements used in the disposition of failed banks. Good bank-bad bank structures involve, like DART, a transfer of distressed assets to a separate entity to let the bank focus on core banking functions. But they usually require a federal subsidy to make the bad bank viable, and the FDIC loss-sharing program has only been used to help dispose of assets after banks have been closed. Unlike these structures, DART does not require a subsidy.

This is the perfect opportunity to revisit the toxic-loan problem and, and get it right this time. By adopting an approach that does not fatally impair capital, provide a taxpayer-supported windfall or burden the federal budget we can prevent another false start and finally restore our banking system to financial health.